Futures more hawkish on Fed rates

Contracts show increased odds for December hike

By

RachelKoning

CHICAGO (CBS.MW) - So much for all-but-certain Federal Reserve inaction in December.

Short-term interest-rate futures contracts traded at the Chicago Board of Trade now reflect increased odds the central bank will raise U.S. interest rates at each of its next few meetings, including on Nov. 10 and at the final meeting of the year on Dec. 14.

The fed funds futures contracts will probably continue to reflect even greater odds for a December hike and no pause from the Federal Reserve in early 2005, said Daniel Jester, an analyst with research firm Economy.com. He tracks the futures markets on a daily basis.

The contracts show interest-rate hedgers now see just under 50/50 odds that the Fed raises rates by a quarter-point at its December meeting. A few weeks ago, futures markets were pricing in almost no chance for a move in December. Futures remain firm in their prediction for a quarter-point rate hike at the Fed's Nov. 10 meeting.

The fed funds futures contracts started to reflect increased odds for higher interest rates in December just after the release of meeting minutes from the Fed's August policy meeting, said Jester.

At that meeting, members saw the need for "significant cumulative" rate increases. See related story.

The minutes were released Sept. 23, two days after the Fed raised interest rates for the third time this year, taking its target rate to 1.75 percent.

Jester explained that some decline in the fed funds futures prices, which means their yields rise, can be tied to an expected shift in contract positions after the conclusion of the Fed's latest policy meeting.

Another short-term interest-rate instrument, the Eurodollar contracts traded at the Chicago Mercantile Exchange, show a strong chance for a November hike and some increased chance for a follow-up move in December.

The futures markets and the broader bond market were convinced that the December meeting would be skipped even as the Fed holds fast to its pledge for a "measured" series of rate hikes.

The Fed has historically skipped December moves in rate-tightening cycles for no hard-and-fast reason in most cases other than it's the end of the year and because it's the Christmas spending season, said former Federal Reserve economist Bob Gay, now an interest-rate strategist with Commerzbank Securities.

Whether based simply on the calendar or on economic fundamentals, the "pause scenario" was one of the drivers behind the bond market's rally in prices and tumble for benchmark yields to April lows below 4 percent late last month.

The market's uncertainty for Fed rates has been reflected in recent action.

The bond market reversed, to trade sharply lower last week and Monday, taking the 10-year yield back up near 4.23 percent. Last week's move was the biggest one-week yield jump since early May. See Bond Report.

Part of the difficulty in using interest-rate futures and the bond market to determine probable Fed action right now is the fact that economic indicators are showing stronger economic growth, which is bearish for bonds, and tame inflation, which is bullish for bonds.

Additionally, the futures market becomes a less-reliable predictor for meetings that are several months out.

Despite recent fluctuations in the near-term contract months, Eurodollar futures contracts out several months continue to show the likelihood of a slower pace of rate changes or a pause at the Federal Reserve next year.

Eurodollar contracts reflect a 2.5 percent Fed interest-rate target by the end of 2005, only 0.75 percentage points above the current rate.

That prediction is about the median of the range of the several economists in the private sector that track the rates, said James O'Sullivan, economist at UBS.

Jester said the futures contracts become "wishy-washy" when you start eying the summer months.

He's not certain if the 2.5 percent Fed funds rate also reflected in CBOT contracts truly indicates a pause on the part of the central bank or general uncertainty in the futures market in making predictions that far out.

O'Sullivan and fellow UBS economists think the futures markets may have it wrong.

UBS predicts a fed funds target of 4 percent by the end of 2004 and a 10-year yield closer to 5.5 percent.

"Either bond yields are likely to move higher, or Fed tightening is almost complete -- we believe the former," said O'Sullivan.

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